History Suggests Operation Twist Should Get More Airtime

Anyone who has been following
Federal Reserve Chairman Ben S. Bernanke’s latest foray into
unconventional monetary policy, nicknamed Operation Twist, may
think the Fed is up to something new.

It isn’t, really: Operation Twist is a modern cover of an
early 1960s classic by the same name, a policy initiated during
John F. Kennedy’s administration and dubbed “Twist” after Chubby Checker’s inescapable 1960s dance craze.

The goal of the Fed’s current “maturity extension program”
-- in which it exchanges $45 billion of short-term Treasuries
each month for longer-term government debt -- is primarily to
lower long-term rates, forcing investors to seek substitute
securities and thereby easing financial conditions more broadly.
The policy is scheduled to expire at the end of the month.

Bernanke has been far more committed to this golden oldie
than were Operation Twist’s initial overseers, and this time the
board’s interest-rate shimmy appears to be paying off. With the
housing market rebounding on the back of low long-term borrowing
rates, the Fed policy makers who are meeting in Washington today
should consider spinning Checker’s track well into 2013.

Two Steps

The original Operation Twist, which began in February 1961,
was a two-part maneuver. First, the Fed sold short-term
securities in an effort to raise short-term yields. At the time,
the country’s balance-of-payments deficit meant gold was leaving
more quickly than it was coming in. By raising yields, the Fed
hoped to bring liquid foreign funds back to the U.S. Otherwise,
these outflows threatened to deplete gold reserves and undermine
the dollar, the basis of the Bretton Woods international
monetary system.

Second, the Fed used the revenue from these sales to buy
long-term Treasury securities, hoping to bring long-term
interest rates down. If effective, this would help spur domestic
investment and residential construction, boosting an economy
still recovering from the 1958 recession.

The term Twist, then, was meant to signify the twisting of
the yield curve, such that the Fed decreased the spread between
short- and long-term rates. (The plan was originally called
“nudge” by the Kennedy administration, because its primary goal
was to nudge long-term rates downward. The name Twist emerged
after the dance entered mainstream culture and the balance-of-
payments deficiency necessitated raising short-term rates.)

Still, while selling short and buying long was simple
enough in theory, at the time the Fed was more accustomed to
dancing a one-step. Since 1953, the board had practiced a strict
“bills only” policy, meaning that it pursued its mandate only by
conducting open-market operations in short-term government
securities.

The incoming Kennedy administration expected the Fed to
pick up its feet. During the 1960 presidential campaign, Kennedy
spoke out strongly against the Fed’s conservative bills-only
strategy and instead advocated an easier monetary policy that
would lower rates and spur the domestic economy. In Congress,
Texas Representative Wright Patman and Illinois Senator Paul H.
Douglas pursued a similar agenda, cajoling Federal Reserve
Chairman William McChesney Martin to broaden the scope of the
central bank’s action.

Martin and the rest of the Fed’s policy board were
reluctant. Operation Twist would be a major break from previous
policy and, more importantly, could compromise the Fed’s
independence. From World War II to March 1951, the Treasury
Department had maintained veto power over the Fed’s interest-
rate decisions, and members of the Reserve Board didn’t want to
resume dancing to the administration’s tune.

Urgent Experiment

Increasing political pressure, and particularly Kennedy’s
election in November 1960, forced the board to act. “Experiment
was urgent because of the system’s public-relation problem,”
Martin explained to the Fed’s policy committee. Most members
were resistant, but Martin was determined to “escape from the
charge of doctrinaire commitment to a laissez faire, free
private market position,” and in the end all but one member
voted to undertake Operation Twist.

In February 1961, like grandparents at a wedding reception,
the Fed eased its way out onto the dance floor and began to
twist noncommittally, experimenting with the new dance while
also hoping the song would end so it could go back to its seat
at the back of the room. But the policy, like the song it was
named after, stayed on repeat throughout the early 1960s.

So the Fed kept twisting, though at the time no one knew if
the policy was having the desired effect, or, for that matter,
any effect. Martin remained pessimistic and pursued Operation
Twist with limited enthusiasm. Proponents such as economist
James Tobin, pointing to Martin’s recalcitrance, maintained that
the theory never really got a fair try. At the time, no
systematic study was undertaken and all sides relied on
anecdotal evidence to support their positions.

Retrospective analyses are mixed. As economist Allan Meltzer concluded in his study of the Reserve Board over this
period, the effort to raise short-term rates seems to have been
effective, and likely reversed some dollar outflows. Yet the
size of the balance-of-payments deficit meant that money still
went out of the country faster than it came in. The Kennedy
administration, and later Lyndon B. Johnson’s, eventually turned
to stronger monetary controls like the interest equalization tax
of 1963, which did little besides push international banking
overseas.

Long-term rates remained little changed through 1964, a
success for the policy when viewed beside rising short-term
rates: The yield curve did in fact twist. And although long-term
rates didn’t fall as intended, the Fed’s purchase of Treasury
bonds may have nudged investors into other securities, such as
corporate bonds. A stronger commitment to Operation Twist by the
Martin board might have nudged them further still.

With interest rates unlikely to fall more, such
substitution is surely what Bernanke had in mind when he
recalled this once-forgotten classic last year. Yet the Twist’s
current remix is set to go off air this month. For the sake of
the housing market, which is still in the early stages of
recovery, we should hope that he hits play on that track one
more time.